Dropping Knowledge: What is an ETF?

March 12, 2011

Lately, I’ve been seeing a lot of commercials about “ETFs” and how companies will invest your money safely in ETFs.  So, what is an ETF?  ETF is short for an “Exchange Traded Fund” which, according to Bloomberg is:

a basket of securities that track an index such as the Standard & Poor’s 500 Index. ETFs, which are available to individual investors only through brokers and advisers, trade like stocks on an exchange

Basically, a manager puts together a combination of securities that should increase and decrease in an equal amount to the index its set to track.  For instance, if the ETF is set to track the S&P 500, it will include stocks, bonds, etc. to make sure that if the S&P increases by 1%, the ETF will increase by 1%.

Now, this seems like a good investment product because your investment can match (or slightly beat) the market.  The problem comes in when the ETF (a “synthetic” product) trades differently because of the nature of the product.  For instance, an ETF is an excellent way to bet against the market, because you can “short” the ETF.  So, the ETF, which trades independently, can be effected by short sellers who aren’t shorting the actual S&P 500.

When the S&P is the benchmark, it’s pretty simply followed.  The problem, and real risk comes into play when the ETF tracks “China’s Car Industry” index or other less transparent indices.

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